An Explication of Personal Income Tax, Excise Tax and State Sales Tax

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Three examples of taxes are a personal income tax, an excise tax like that imposed on cigarettes and alcohol in the U.S., and a state sales tax. The first two are sources of revenue for the federal government. Individuals must file income tax returns each year, paying a certain percentage on each portion of their income as determined by tax brackets. The second tax is a fee which producers of these products are required to pay the government for each unit of output in order to legally continue production.

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The last tax is a percentage added onto the purchase of most goods and services.

Fairness as I see it has to do with personal accountability, so while I endorse the concept of vertical equity, I do not agree with either the ability- to-pay principle or excessive income redistribution. I believe in the benefit principle and the idea that people should put in what they take out, which in some cases conflicts with horizontal equity.

Under these terms, the U.S. progressive federal income tax is a fair system. Everybody benefits from at least some of the services of the federal government, such as national defense, disaster relief, education, technology, etc; thus, it is consistent with the benefit principle. Next, this tax is consistent with vertical equity. It only makes sense that those with the means should give a larger portion of their incomes to support these services than those who can barely make ends meet; the reasoning is that people with lower incomes derive more marginal utility from each dollar they spend since the cost of necessities takes up a larger portion of their income.

Allocative efficiency is reached at a level of production where the ratio of marginal utility gained from a good to marginal cost in resources used to produce the good is equal to the same ratio for all other goods.

Unfortunately, the income tax decreases allocative efficiency; by reducing after-tax income, the cost of labor and thus the costs of production increase, so firms must decrease output to keep marginal cost equal to marginal revenue. At this level of output, marginal social benefit is higher than marginal cost excluding the tax, so overall satisfaction could be maximized by increasing output. Under an income tax, too little is produced for allocative efficiency.

The excise taxes on cigarettes and alcohol are similar to state sales taxes in terms of fairness. In the case of the excise tax, the tax is essentially transferred to the consumer through higher prices charged by the producer, but regardless of income or wealth, consumers of the respective products pay a certain fee on each purchase as a percentage of that purchase. If there is no indication that a high-income consumer purchases more of these goods than a low-income consumer, then vertical equity is violated because the amount spent on these goods represents a larger portion of income for the low-income consumer than for the high-income consumer. The high-income consumer receives less marginal utility per dollar of income than the low- income consumer, because the high-income consumer can easily afford necessities with change to spare, while the low-income consumer struggles to afford anything more than basic necessities; thus, the opportunity cost of spending the same amount of money on other goods is lower for the high- income consumer. In other words, the high-income consumer derives the same amount of utility as the low-income consumer but at a lower cost. For the most part, this is unfair.

In terms of efficiency, the excise taxes on alcohol and cigarettes differ from state sales taxes. There are external costs associated with consumption of alcohol and cigarettes; when smokers and alcoholics rely on the government to cover their medical expenses, the burden falls on society in the form of taxes. At market equilibrium, the marginal social costs are higher than the marginal social benefits. Overall satisfaction could be increased by reducing production of cigarettes and alcohol. The excise tax increases the marginal cost of production so that it is now above marginal revenue; firms must scale back production in order to keep marginal cost just equal to marginal revenue. Market output decreases and the market approaches allocative efficiency.

The sales tax on the other hand negatively effects allocative efficiency. Assuming there are no external costs or benefits associated with the goods being consumed, the market is already at allocative efficiency, so any deviation from the market equilibrium will result in a loss of allocative efficiency. With the tax, marginal cost is greater than marginal revenue, so firms reduce output and supply decreases. Too little is produced for allocative efficiency.

The income tax is fair but decreases allocatively efficiency. The excise tax is unfair but increases allocatively efficiency. The sales tax is unfair and decreases allocative efficiency. Either the income tax or the excise tax could be considered best, but the excise tax is slightly better because there is a justifiable way to prove that it is fair based on the benefit principle. Because people who drink and smoke regularly benefit from medical care paid for by tax payers by proxy through the government, they bear more of the burden through excise taxes than those who don't consume these goods.